Introduction to Analyzing Financial Statements

There are various methods and techniques to perform Financial Statement Analysis. However, the most common methods of financial statement analysis include the following:

Horizontal Analysis:

A horizontal analysis is a comparison of financial statements with that of two or more previous years and its elements. Horizontal analysis allows investors and analysts to see what has been driving a company’s financial performance over a number of years, as well as to spot trends and growth patterns such as seasonality. It enables analysts to assess relative changes in different line items over time, and project them into the future. By looking at the income statement, balance sheet, and cash flow statement over time, one can create a complete picture of operational results, and see what has been driving a company’s performance and whether it is operating efficiently and profitably. It can either use absolute comparisons or percentage comparisons, where the numbers in each succeeding period are expressed as a percentage of the amount in the baseline year, with the baseline amount being listed as 100%. This comparison provides analysts with insight into the aspects that could contribute significantly to the financial position or profitability of the organization.

Vertical Analysis:

Vertical analysis is a method of analyzing financial statements that list each line item as a percentage of a base figure within the statement. One line item of the statement always shows the base figure at 100%, with each of the other items representing a percentage of the base figure. For example, each line of an income statement represents a percentage of Revenues, while each line of a balance sheet represents a percentage of Total Assets & Liabilities. One can use vertical analysis on an income statement, balance sheet or cash flow statement to understand the proportions of each line item to the whole, understand key trends that occur over time, compare multiple companies of varying sizes or compare a company’s financial statements to averages within their industry.

Ratio analysis:

Ratio analysis refers to the analysis of various pieces of financial information in the financial statements of a business which are mainly used external analysts to determine various aspects of a business. Generally, ratios are typically not used in isolation but rather in combination with other ratios. This data can also compare a company’s financial position with industry averages while measuring how a company stacks up against others within the same sector. Following are the uses of Ratio Analysis:

• Comparisons: One of the uses of ratio analysis is to compare a company’s financial performance to similar firms in the industry to understand the company’s position in the market. Obtaining financial ratios for known competitors and comparing it to the company’s ratios can help management identify market gaps and examine its competitive advantages, strengths, and weaknesses. The management can then use the information to formulate decisions that aim to improve the company’s position in the market.
• Trend line: Companies can also use ratios to see if there is a trend in financial performance. Established companies collect data from the financial statements over a large number of reporting periods. The trend obtained can be used to predict the direction of future financial performance, and also identify any expected financial turbulence that would not be possible to predict using ratios for a single reporting period.
• Operational efficiency: The management of a company can also use financial ratio analysis to determine the degree of efficiency in the management of assets and liabilities. Inefficient use of assets such as motor vehicles, land, and building results in unnecessary expenses that ought to be eliminated. Financial ratios can also help to determine if the financial resources are over- or under-utilized.

There are four different ways to represent Financial ratios given their nature:

• Simple or Pure – A simple ratio is shown as a quotient, example – 3:1
• Percentage – This type of representation is done in form of a percentage, example 30%
• Turnover Rate or Times – Accounting ratio expressed in form of rate or times, example 3 times.
• Fraction – It is when a ratio is expressed in a fraction, example 2/3 or 0.67

Types of Ratios:

• Liquidity Ratios:This type of ratio helps in measuring the ability of a company to take care of its short-term debt obligations. A higher liquidity ratio represents that the company is highly rich in cash. The types of liquidity ratios are:
  • Current Ratio – The current ratio is the ratio between the current assets and current liabilities of a company. The current ratio is used to indicate the liquidity of an organization in being able to meet its debt obligations in the upcoming twelve months. A higher current ratio will indicate that the organization is highly capable of repaying its short-term debt obligations. Numerically, it is represented as:

    Current Ratio = Current Assets/Current Liabilities

  • Quick Ratio – The quick ratio is used to ascertain information pertaining to the capability of a company in paying off its current liabilities on an immediate basis. Numerically, it is represented as:

    Quick Ratio = (Cash and Cash Equivalents + Marketable Securities + Accounts Receivables)/Current Liabilities

• Profitability Ratios:This type of ratio helps in measuring the ability of a company in earning sufficient profits. The types of profitability ratios are:
• Gross Profit Ratios:Gross profit ratios are calculated to represent the operating profits of an organization after making necessary adjustments pertaining to the COGS or cost of goods sold. Numerically, it is represented as:

  Gross Profit Ratio = (Gross Profit/Net Sales) * 100

• Operating Profit Ratio:Operating profit ratio is used to determine the soundness of an organization and its financial ability to repay all the short term and long-term debt obligations. Numerically, it is represented as:

  Operating Profit Ratio = (Earnings Before Interest and Taxes/Net Sales) * 100

• Net Profit Ratio:Net profit ratios are calculated to determine the overall profitability of an organization after reducing both cash and non-cash expenditures. Numerically, it is represented as:

  Net Profit Ratio = (Net Profit/Net Sales) * 100

• Return on Equity (ROE): Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders’ equity.

  ROE = Net Profit/Shareholder’s Equity

• Return on Capital Employed (ROCE): Return on capital employed is used to determine the profitability of an organization with respect to the capital that is invested in the business. Numerically, it is represented as:

  ROCE = Earnings Before Interest and Taxes/Capital Employed

• Solvency Ratios:Solvency ratios can be defined as a type of ratio that is used to evaluate whether a company is solvent and well capable of paying off its debt obligations or not. The types of solvency ratios are:
  • Debt Equity Ratio:The debt-equity ratio can be defined as a ratio between total debt and shareholders fund. The debt-equity ratio is used to calculate the leverage of an organization. An ideal debt-equity ratio for an organization is 2:1. Numerically, it is represented as:

    Debt Equity Ratio = Total Debts/Shareholders Fund

  • Interest Coverage Ratio:The interest coverage ratio is used to determine the solvency of an organization in the nearing time as well as how many times the profits earned by that very organization were capable of absorbing its interest-related expenses. Numerically, it is represented as:

    Interest Coverage Ratio = Earnings Before Interest and Taxes/Interest Expense

• Turnover Ratios: Turnover ratios are used to determine how efficiently the financial assets and liabilities of an organization have been used for the purpose of generating revenues. The types of turnover ratios are:
  • Fixed Assets Turnover Ratios:Fixed assets turnover ratio is used to determine the efficiency of an organization in utilizing its fixed assets for the purpose of generating revenues.Numerically, it is represented as:

    Fixed Assets Turnover Ratio = Net Sales/Average Fixed Assets

  • Inventory Turnover Ratio:Inventory turnover ratio is used to determine the speed of a company in converting its inventories into sales. Numerically, it is represented as:

    Inventory Turnover Ratio = Cost of Goods Sold/Average Inventories

  • Receivable Turnover Ratio:Receivable turnover ratio is used to determine the efficiency of an organization in collecting or realizing its account receivables.Numerically, it is represented as:

    Receivables Turnover Ratio = Net Credit Sales/Average Receivable

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